Chapter 5: The Standard Trade Model 1. The concept “terms of trade” means A. the amount of exports sold by a country. B. the price conditions bargained for in international markets. C. the price of a country's exports divided by the price of its imports. D. the quantities of imports received in free trade. E. None of the above. Answer: C 2. A country cannot produce a mix of products with a higher value than where A. the isovalue line intersects the production possibility frontier. B. the isovalue line is tangent to the production possibility frontier. C. the isovalue line is above the production possibility frontier. D. the isovalue line is below the production possibility frontier. E. the isovalue line is tangent with the indifference curve. Answer: B 3. Tastes of individuals are represented by A. the production possibility frontier. B. the isovalue line. C. the indifference curve. D. the production function. E. None of the above. Answer: C 4. If PC / PF were to increase in the international marketplace, then A. all countries would be better off. B. the terms of trade of cloth exporters improve. C. the terms of trade of food exporters improve. D. the terms of trade of all countries improve. E. None of the above Answer: B 5. If PC / PF were to increase, A. the cloth exporter would increase the quantity of cloth exports. B. the cloth exporter would increase the quantity of cloth produced. C. the food exporter would increase the quantity of food exports. D. Both A and C. E. None of the above. Answer: B
56
6. If PC / PF A. B. C. D. E.
were to increase, world relative quantity of cloth supplied and demanded increases. world relative quantity of cloth supplied and demanded decreases. world relative quantity of cloth supplied increases.. world relative quantity of cloth demanded decreases . None of the above.
Answer: C 7. When the production possibility frontier shifts out relatively more in one direction, we have A. biased growth. B. unbiased growth. C. immiserizing growth. D. balanced growth. E. imbalanced growth. Answer: A 8. Export-biased growth in Country H will A. improve the terms of trade of Country H. B. trigger anti-bias regulations of the WTO. C. worsen the terms of trade of Country F (the trade partner). D. improve the terms of trade of Country F. E. decrease economic welfare in Country H. Answer: D 9. Immiserizing growth is A. likely to occur if the exporting country is poor. B. likely to occur if the exporting country is rich. C. likely to occur when terms of trade change. D. likely to occur if relative supplies are elastic. E. None of the above. Answer: E 10. If the U.S. Agency for International Development transfers funds to poor countries in Sub-Saharan Africa, this must A. worsen the U.S. terms of trade. B. improve the U.S. terms of trade. C. worsen the terms of trade of the African aid recipients. D. improve the terms of trade of the African aid recipients. E. None of the above. Answer: E
57
11. If the poor AID recipient countries have a higher marginal propensity to consume each and every product than does the United States, then such aid will A. worsen the U.S. terms of trade. B. improve the U.S. terms of trade. C. leave the world terms of trade unaffected. D. worsen the terms of trade of both donor and recipient countries. E. None of the above. Answer: B 12. If a large country imposes a tariff on its imported good, this will tend to A. have no effect on terms of trade. B. improve the terms of trade of all countries. C. improve the terms of trade of the United States. D. cause a deterioration of U.S. terms of trade. E. raise the world price of the good imported by the United States. Answer: C 13. A country will be able to consume a bundle which is not attainable solely from domestic production only if A. the world terms of trade differ from its domestic relative costs. B. the country specializes in one product. C. the country avoids international trade. D. the world terms of trade equal the domestic relative costs. E. None of the above. Answer: A 14. Terms of trade refers to A. what goods are imported. B. what goods are exported. C. the volume of trade. D. the prices at which trade occurs. E. None of the above. Answer: D 15. If points a and b are both on the production possibility frontier of a country, then A. consumers are indifferent between the two bundles. B. producers are indifferent between the two bundles. C. at any point in time, the country could produce both. D. Both cost the same. E. The country could produce either of the two bundles. Answer: E
58
16. If the economy is producing at point a on its production possibility frontier, then A. all of the country's workers are specialized in one product. B. all of the county's capital is used for one product. C. all of the county's workers are employed. D. all of its capital is used, but not efficiently. E. None of the above. Answer: C 17. If at point A on the production possibility frontier, and the community indifference curve cuts through point a from northwest to southeast, then the optimal autarky production bundle is A. at point A. B. to the right of point A. C. to the left of point A. D. to the northeast of point A. E. to the southwest of point A. Answer: B 18. A bundle indicated by a point to the northeast of the production possibility frontier is A. unattainable at a point in time. B. unattainable at a point in time without international trade. C. unattainable at a point in time without domestic trade. D. unattainable as a consumption point. E. None of the above. Answer: B 19. If two countries with diminishing returns and different marginal rates of substitution between two products were to engage in trade, then A. the shapes of their respective production possibility frontiers would change. B. the marginal rates of substitution of both would become equal. C. the larger of the two countries would dominate their trade. D. the country with relatively elastic supplies would export more. E. None of the above. Answer: B
59
20. If a country began exporting product A and importing product B, then, as compared to the autarky (no-trade) situation, the marginal cost of product A will A. increase. B. decrease. C. shift outward. D. shift inward. E. None of the above. Answer: A 21. If, beginning from a free trade equilibrium, the terms of trade improve for a country, then it will A. increase production of its import competing good. B. increase consumption of its export good. C. increase the quantity of its imports. D. experience an export-biased shift in its production possibility frontier. E. None of the above. Answer: C 22. An increase in a country's net commodity terms of trade will always A. increase the country's economic welfare. B. increase the country's real income. C. increase the country's quantity of exports. D. increase the country's production of its import competing good. E. None of the above. Answer: E 23. After WWI, Germany was forced to make large reparations - transfers of real incometo France. If the marginal propensity to consume was equal in both countries, and if France's demand was biased toward food (relative to Germany's demand pattern) then we would expect to find A. the world's relative price for food remains unchanged. B. the world's relative price for food increase. C. the world's relative price for food decrease. D. the world relative price for both food and non-food rise. E. None of the above. Answer: B
60
24. If we add to Question 23 that France exported manufactures, whereas Germany exported food, then the reparations from Germany to France would A. improve France's international terms of trade. B. cause France' terms of trade to deteriorate. C. cause both France' and Germany's terms of trade to deteriorate. D. cause both France' and Germany's terms of trade to improve. E. None of the above. Answer: B 25. If a country lent money to another, this must A. lower the terms of trade of the recipient country. B. lower the terms of trade of both countries. C. improve the terms of trade of the recipient country. D. improve the terms of trade of the donor country E. None of the above. Answer: E 26. During the 19th Century, economic growth of the major trading countries was biased toward manufactures and away from food. The less developed countries of that time were net exporters of food. From this information, we would expect to have observed A. falling terms of trade for the less developed countries. B. improving (rising) terms of trade for the less developed countries. C. no change at all in the terms of trade of the less developed countries. D. a decrease in the relative price of food. E. None of the above. Answer: B 27. Immiserizing growth could occur to A. a poor country experiencing export-biased economic growth. B. a poor country experiencing import-biased economic growth. C. a poor country experiencing growth in its non-traded sector. D. a poor country experiencing capital-intensive biased growth. E. None of the above. Answer: A
61
28. A large country experiencing import-biased economic growth will tend to experience A. positive terms of trade. B. deteriorating terms of trade. C. improving terms of trade. D. immiserizing terms of trade. E. None of the above. Answer: C 29. In the period preceding the recent Financial Crisis in Asia, the South East Asian countries were receiving large inflows of financial capital. Following John Maynard Keynes' theory, this should have caused A. a glut in their banking asset situation. B. an improvement in their terms of trade. C. deterioration in their terms of trade. D. a fluctuation upward and then downward in their terms of trade. E. None of the above. Answer: B 30. If Slovenia is a small country in world trade terms, then if it imposes a large series of tariffs on many of its imports, this would A. have no effect on its terms of trade. B. improve its terms of trade. C. deteriorate its terms of trade. D. decrease its marginal propensity to consume. E. None of the above. Answer: A 31. If Slovenia is a large country in world trade, then if it imposes a large set of tariffs on many of its imports, this would A. have no effect on its terms of trade. B. improve its terms of trade. C. deteriorate its terms of trade. D. decrease its marginal propensity to consume. E. None of the above. Answer: B
62
32. If Slovenia were a large country in world trade, then if it imposes a large set of tariffs on its imports, this must A. cause retaliation on the part of its trade partners. B. harm Slovenia's real income. C. improve Slovenia's real income. D. improve the real income of its trade partners. E. None of the above. Answer: E 33. If Slovenia were a large country in world trade, then if it instituted a large set of subsidies for its exports, this must A. have no effect on its terms of trade. B. improve its terms of trade. C. deteriorate its terms of trade. D. decrease its marginal propensity to consume. E. None of the above. Answer: C 34. If Slovenia were a large country in world trade, then if it instituted a large set of subsidies for its exports, this must A. cause retaliation on the part of its trade partners. B. harm Slovenia's real income. C. improve Slovenia's real income. D. improve the real income of its trade partners. E. None of the above. Answer: D 35. If the United States exports skilled-labor intensive products and services, then we should expect unions representing skilled labor to A. lobby in favor of tariffs. B. lobby against the imposition of tariffs. C. be indifferent to the issue of tariffs. D. lobby in favor of improved terms of trade. E. Not enough information. Answer: E
63
36. If the United States exports skilled-labor intensive products and services, then we should expect unions representing unskilled labor to A. lobby in favor of tariffs. B. lobby against the imposition of tariffs. C. be indifferent to the issue of tariffs. D. lobby in favor of improved terms of trade. E. Not enough information. Answer: B 37. If a there are no international loans or capital flows, then if a country's terms of trade improve, we would find that A. the value of its exports exceeds the value of its imports. B. the value of its exports becomes less than that of its imports. C. the value of its exports exactly equals that of its imports. D. the quantity of its exports equals that of its imports. E. None of the above. Answer: C
64
Essay Questions 1.
Other things being equal, a rise in a country's terms of trade increases its welfare. What would happen if we relax the ceteris paribus assumption, and allow for the law of demand to operate internationally?
Answer: Let us assume that the terms of trade (or technically the net commodity terms of trade) improve, thus the relative price of a country's exports increase. This would, logically, lead to a shift away by world consumers to substitute goods. If the demand for a country's exports is elastic, the quantity decrease would be proportionally larger than the per unit price increase. This term of trade effect would actually lower the country's real income and economic welfare. 2.
If a country's growth is biased in favor of its import, this should unequivocally improve its terms of trade and its economic welfare. Discuss.
Answer: Suppose Japan experiences economic growth biased in favor of its import substitutes. For example, assume that Japan imports components and exports final goods, but that it experiences a major growth in its components manufacture sector. Since Japan is internationally a large country in these markets, this would tend to hurt its component supplier's terms of trade (and help Japan's). However, such a bias in economic growth may tend to lessen the volume of international trade. At an extreme, Japan may become an exporter of components and an importer of final goods. If the result is a lessening of specialization and of the volume of trade, then this effect will lower Japan's welfare associated with gains from trade. If an actual change in the pattern of comparative advantage occurs (a possibility) this may cause dynamic dislocations whose harm overpowers static gains for a relatively long period of time. 3.
It is impossible for economic growth in a small country to lower that country's economic welfare, regardless of the bias of the growth. Explain.
Answer: This is a true statement. The reason economic growth may hurt a country is if the terms of trade effect counters and dominates the growth effect. In the case of the small country there is no terms of trade effect.
65
4.
At the conclusion of World War I, Germany, as a punishment, was obliged to make a large transfer to France in the form of reparations. Is it possible that the actual reparations may have improved Germany's economic welfare?
Answer: Such a result is not likely. However, theoretically, if France's income elasticity of demand for Germany's exports was higher than Germany's income elasticity of demand for its own exportable, then the real income transfer associated with these reparations may have improved Germany's terms of trade, and improved its balance of payments, thus helping Germany in manner unanticipated in the Treaty of Verssaille. Explain. 5.
An export subsidy has the opposite effect on terms of trade to the effect of an import tariff. Domestically a tariff will raise the price of the import good, deteriorating the domestic terms of trade. A production subsidy for the export product will lower the local price of the export good, lowering the domestic terms of trade for the country. Hence the export subsidy and the import tariff have the same effect. This analysis seems to contradict the first sentence in this paragraph. Discuss this paradox.
Answer: While this (Lerner) equivalence may well occur domestically, internationally the tariff will improve a country's terms of trade. An export subsidy on the other hand will in fact lower the international price of the (now readily available) export good, hence hurting a country's terms of trade.
66
Quantitative/Graphing Problems
1.
Albania refused to engage in international trade for ideological reasons. To maximize its economic welfare it would choose to produce at which point in the diagram above? Suppose the PA/PB at point a was equal to 1. Given this information, in which good (A or B) does Albania enjoy a comparative advantage? Now that the Cold War is over, Albania is interested in obtaining economic welfare gains from trade. The relevant international relative price is PA/PB =2. Albania would therefore choose to produce at which point (a, b, or c)? Given this additional information, in which good does Albania enjoy a comparative advantage?
Answers: Albania would choose to produce at point a. With no reference to world terms of trade, one cannot establish Albania's comparative advantage. Later, when Albania discovers that the relative price of A equals twice the price of B, it knows that it has a comparative advantage in A. Therefore Albania would produce at production point b. 2.
Now, suppose that the relative price of A is actually not higher than Albania's autarkic level of 1, but quite the opposite (e.g. PA/PB = 0.5). Would Albania still be able to gain from trade? If so, where would be its production point? Given the information in this question, where is Albania's comparative advantage?
Answer: Yes. As long as the world's terms of trade differed from those of Albania, that country stands to gain from international trade. In this particular case, its point of production with trade would be at point c.
67
3.
Suppose, as a result of various dynamic factors associated with exposure to international competition, Albania's economy grew, and is now represented by the rightmost production possibility frontier in the Figure above. If its point of production with trade was point c, would you consider this growth to be exportbiased or import biased? If Albania were a large country with respect to the world trade of A and B, how would this growth affect Albania's terms of trade? Its real income?
Answer: If point c is the production point with trade, then Albania has a comparative advantage in good B. Therefore, from the shape of the new production possibility frontier (as compared to the original one), this is clearly an export-biased growth. This ceteris paribus would tend to worsen Albania's terms of trade. The terms of trade effect would, again ceteris paribus, worsen its real income. However, the growth itself acts in the opposite direction. 4.
Suppose, as a result of various dynamic factors associated with exposure to international competition, Albania's economy grew, and is now represented by the rightmost production possibility frontier in the Figure above. If its point of production with trade was point b, would you consider this growth to be exportbiased or import biased? If Albania were a large country with respect to the world trade of A and B, how would this growth affect Albania's terms of trade? Its real income? What if Albania were a small country?
Answer: If the production with trade point was point b, then the observed growth is a case of import-biased growth, and would improve Albania's terms of trade. If Albania were a small country, the world's terms of trade would not change at all. In such a case, economic growth (with no induced change in income distributions) would always increase its real income.
68
5.
Suppose Albania is exporting product B, and experienced economic growth biased in favor of product B as seen in the Figure above. We are also told that Albania's new consumption point is at point d. Would you still consider the economic growth, which took place biased in favor of B? If Albania were a large country how would this growth affect its terms of trade?
Answer: This is a relatively difficult case. On the one hand, the growth is still technically export biased. However, Albania's consumption clearly shifted in favor of its import product, A. In this case, the deterioration in the terms of trade would be much more pronounced than before, and may lead to a case of immiserizing growth. However, for this to occur, there must have been a major shift in the taste patterns (the old community indifference map is not longer applicable). Therefore, when we try to judge the direction and magnitude of the welfare change, we are comparing the old versus new taste preferences, which raises the classic index number problem.
69
